- After Fastly's Q1 earnings, I explained why I wasn't a buyer of the stock.
- Q2's earnings, released Wednesday, were equally disappointing and confirmed that the company has major problems.
- Fastly stock, despite the big drop, remains expensive.
- Shares would have to fall much further to attract bargain shoppers.
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Back in May, I published an article laying out why I Wasn't Buying Fastly. This wasn't a popular position. After all, Fastly (NYSE:FSLY) stock had tumbled from over $100 not that long ago to under $50, and people were looking to buy the dip. My article was the only outright bearish one published about Fastly on Seeking Alpha since February.
In any case, Fastly's Q2 results confirmed the bearish view on the company. FSLY stock tumbled once again Wednesday evening following another downbeat earnings report and double-digit cut to revenue guidance going forward:
If Fastly stock opens around $36 during regular trading hours, it will be at its lowest point since last May.
“During the second quarter, we also managed through a significant outage that impacted our Q2 results and will have an impact on our Q3 and full year outlook. We have a couple of customers, one of them being a top 10 customer, that have yet to return their traffic to the platform. We also had several customers delay the launch of certain projects, which delayed the timing of traffic coming onto our platform".
However, that incident may not be the only factor causing the weak results. Fastly is facing the same problem that a lot of tech companies have had this earnings season: It's hard to beat last year's comps.
2020 gave tech companies a once-in-a-lifetime opportunity to find new clients and pitch their services far and wide. Just about every company had to suddenly reevaluate its digital strategy and get as much online and virtually accessible as possible. You couldn't ask for better conditions for a company like Fastly. Indeed, FSLY stock leapt from the teens to as high as $135 per share in the wake of the pandemic.
Now, however, the company is up against its sizzling comps from last summer when the lockdowns and quarantines were at maximum impact. And Fastly's Q2 results -- outage or no outage -- were seriously underwhelming.
Source: Seeking Alpha
Losing Money As Growth Slows Down
A huge issue for former high-growth stocks, like Fastly, is that there is simply no clear floor to the valuation. Fastly doesn't generate profits or pay a dividend, so there is no anchor in terms of a P/E ratio or yield to support any value-investment based approach in the stock.
Indeed, Fastly isn't even particularly close to profitability, the company anticipates losing between 57 cents and 65 cents per share on the year. That means that the company will lose approximately $50 million for 2021 on its projected $340-$350 million of revenues. That's a pretty steep negative operating margin for a company whose revenue growth rate has slumped dramatically. And, if you add back in stock comp, the numbers look even worse.
Regardless, either you have to get to at least breakeven, or keep growing quickly so that investors hold out hope that the business will soon scale up. In Fastly's case, it is running large operating losses without adding customers quickly enough to reach an inflection point. That is a toxic combination.
And even at this price, Fastly hardly checks any of the right boxes as far as value goes. The valuation will still be north of $4.0 billion, using a $36 stock price, for just $345 million a year or so of annual revenues. 11x revenues for a slow growth business with operational problems and a chunky net loss would be considered quite expensive in most tech stock environments. I realize this is 2021, and we've moved the goalposts dramatically in terms of what's "normal" for valuations nowadays, but 11x revenues for a business in this much of a tailspin is hardly a deal.
The thinking is probably that somebody like Cisco (CSCO) will come along and buyout Fastly. But is it a pressing need to come in with an offer today while Fastly is still trading north of 10x revenues? Fastly has already warned that customers are reluctant given the troubling service outage in Q2. And Fastly is up against incredibly good comps from last year. All signs point to at least a couple more weak earnings reports coming up in the future, which should let the valuation ratio compress even further. There is little rush for a potential M&A suitor to come in with an offer imminently.
Comparison to Cloudflare
Another interesting point is where Fastly relates to Cloudflare (NET). A big bullish argument for FSLY stock has been that it appears to be much cheaper than Cloudflare.
Prior to this latest earnings miss from Fastly, it appeared to be a reasonable case. Cloudflare, after all, is going for about 60x revenues and has 45% top-line growth. Fastly was going for 14x sales and appeared to be in-line for 30% revenues growth before cutting guidance. Surely Fastly would have to close the gap with Cloudflare stock at some point?
And, looking at the stock charts, there's a massive discrepancy between the two stocks' performance over the past 12 months:
However, the market turned out to be on top of things. It's certainly possibly that Cloudflare shares will tumble as well at some point. However, with each passing quarter, it's becoming more and more apparent that Cloudflare is simply a much better performing business than Fastly, and thus there's no need for Fastly's valuation to ever catch up with Cloudflare's.
Last quarter, Fastly released bad numbers and dropped, meanwhile Cloudflare's numbers were pretty good. Cloudflare shares initially wavered but then quickly rallied following its earnings report. So don't assume that Cloudflare is necessarily going to put up bad numbers simply because Fastly's report was a dud.
Fastly Stock Verdict
There are a few things in the world worse than a growth stock that has stopped growing. It has no natural shareholder base. A stock like Fastly is still far too expensive for value investors. Fastly doesn't come close to turning a profit, so shares would have to fall a lot farther to attract true bargain hunters. Income investors won't touch a company like Fastly since there is no dividend. Momentum traders are likely to be out of Fastly by now, if anything, their models may be pointing to FSLY stock as a short sale candidate.
So the main constituency for Fastly stock are people buying simply because the share price has come down dramatically. That's something, to be sure.
However, there's no guarantee that anything close to $100 was ever a right price for Fastly. Buying simply because the price has dropped dramatically from an unsustainably high peak isn't necessarily a good thesis. There are also people buying in hopes that Fastly's new Chief Revenue Officer can fix the company's sales process. That's possible, but it's risky to buy a turnaround story at more than 10x revenues. Normally, you'd like to see a much lower entry point on a busted growth story such as this one.
At some point, Fastly should finally be able to get some positive momentum going once again. But it could be a while yet. 2020 pulled forward a ton of demand for the tech industry, and we've been seeing the hangover across a bunch of companies reporting earnings this quarter. Fastly put itself in a particularly bad place. Not only was it up against a great Q2 2020, but its service outage weakened its operating results and outlook.
At this point, Fastly needs a turnaround, and it's simply not appealing to buy a turnaround story way up at 11x revenues.
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This article was written by
Ian Bezek is a former hedge fund analyst at Kerrisdale Capital. He has spent the decade living in Latin America, doing the boots-on-the ground research for investors interested in markets such as Mexico, Colombia, and Chile. He also specializes in high-quality compounders and growth stocks at reasonable prices in the US and other developed markets.Ian leads the investing group Learn more .
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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